One giant blind spot plagues every investor. Whether he’s an individual investor or managing a $10 billion fund, he just cannot see U.S. dollar risk. For some reason people cannot perceive the risk to their assets posed by U.S. dollar depreciation.

That’s easy to understand, because the dollar is their numeraire. That means it is the “currency they evaluate everything by.” It is the denominator in all their fractions: 8 cabbages/$1.00, 1 pickup/$8,000, 1 computer/$1,200. They don’t gauge value in terms of cabbages, or pick-ups, or computers, but in terms of their accustomed common denominator, dollars. Mentally, they reduce all values to dollars.

But what happens when the denominator is silently changing all the time? When its value is slipping away, and that slip is difficult to measure? What happens is, they lose value. Worse still, nominal gains – gains in dollar terms alone – may fool them into believing that they have a gain where no gain exists. Worst of all, the US government taxes them on these phantom gains.

Here’s an example. You put $100,000 into a CD paying you 3% interest for a year. At the end of the year, you receive $103,000 back from the bank, and pay taxes on a $3,000 “gain.”

Whoa! That’s all magic, sleight of hand, because while you enjoyed that seen $3,000 gain, unseen ination roared at 8%, chewing away 8% of the dollar’s value. So to determine the actual result of your investment, you have to subtract the inflation loss:

$103,000 – $8,000 = $95,000.

When you take into account ALL the costs including US dollar risk, your $100,000 investment actually lost $5,000 in purchasing power (“value”) over those 12 months. IS IT SELF-EVIDENT?

Moneychanger, why are you digging this up again? Haven’t we already covered this a hundred times?

Yep, maybe so, but people still haven’t gotten it yet, maybe many of you. Many of you reading this recognize it as an abstract fact, but don’t apply it to managing your own investments. And I will guarantee you that most professional investment managers have little or no hedge against the most pervasive risk they face: U.S. dollar depreciation risk. Oh, they may allocate 15% to Inflation Adjusted Treasuries, but that’s about the extent of it. Gold? What’s gold? Silver? What planet does that come from?

U.S. dollar risk

*** What very few investors and professional money managers have grasped is this: gold and silver are alternative currencies. You may not be able to spend them at the corner grocery, but the market is using them as store-of-value, safe-haven money. Both gold and silver are alternative currencies to the U.S. dollar and all other national currencies, so they benefit and will continue to benefit from the fixed inflationary policies of the Federal Reserve, Bank of Japan, European Central Bank, and their governments.

In other words, until the economic and monetary structures in these countries are changed from the ground up, these currencies will continue to lose purchasing power. This is the reality that investors and investment managers ignore. Their plans provides no method of hedging U.S. dollar risk. Oh, if a professional manager is investing in stocks outside the United States he will very carefully hedge the foreign currency risk, all the while he blindly overlooks the domestic currency risk.

Is the prudent man still prudent?

Monetary backdrop. Investment managers labour under a legal obligation called “the prudent man rule.” They have a trust, a “fiduciary obligation,” to invest the funds in their care as a prudent man would invest them under the same conditions. Notice that they are not guaranteeing the investments will pay off, or grow, only that they have acted as a “prudent man.”

Who is that “prudent man”? Well, it turns out he’s the fellow who follows the mainstream and does what most people in his position believe prudent. In other words, he follows the crowd. And that’s fine, as long as the crowd is headed in the right direction. What happens when unperceived changes to circumstances send the crowd down the wrong road? When did the prudent man legal doctrine arise? During the 19th century, over prolonged periods of deflation or monetary stability. During deflation, bonds are the most sensible investment, because deflation (shrinking money supply) makes every currency unit gain value over time. Dollars tomorrow will be worth more than dollars today. Not only does a bond pay interest for using your money, but also when you receive the principal back, it buys more than before.

Likewise under deflation or monetary stability, stocks make sense. Stable money promotes economic growth, and although a deflation generally takes down prices (challenging producers management skills) products from basic industries will always be in demand, even though stocks obviously carry more risk than bonds.

Today’s monetary background is completely the opposite to the 19th century. Today we live in an inflationary world where the currency’s purchasing power steadily falls. That makes all promises to pay dollars tomorrow, like bonds, sure losers. Doesn’t help stocks, either.

Diversification. Then there’s “diversification” in the prudent man rule. As applied, this means don’t put all your eggs into one basket. Put it into 10 baskets, and hope that one or two fill up. I call diversification planning for failure. It presupposes that several of your investments will go hooves up but a few will stand and prosper.

Diversification presupposes that the world is random, and I don’t believe that. Even if I did, I’d prefer to stack the odds in my favour. Rather than plan for failure, I’d prefer to plan for success. I had rather research and study and pick those few investments that I am certain will pay off, and then bet big on them.

Watching the successful

Here’s a little footnote on that idea: one privilege of being a gold and silver broker is that you get to watch some really successful investors and learn their tactics.

One thing they all have in common is their unhesitant boldness scares me to death. I remember one in particular, a cheerful man who passed away recently. Back in the early 2000s he would call and ask, “How much are those 90% bags today?” I’d tell him “$4,250” and he’d say, “Send me five.” Lo, in those lean days that was a blessed bonanza. Then before we could get that order shipped, silver would drop and he’d call back: “How much are those bags today?” “$4,000,” I winced. “Give me 10.”

I watched and watched. As I recall he stopped buying bags around $8,000 or $9,000 not because he began to doubt silver, but because his wife told him their garage was full and he couldn’t buy any more.

Every successful investor follows that pattern. First, they don’t pitty-pat at an investment, buying a tee-tiny tad here and a wee little bit there. Whether they’re millionaires or nickel-rubbers, they know you must bet big to win big.

But they’re not mere reckless gamblers. Before they ever come to me they have done their homework, and they know exactly why the investment should rise, how it works, and when it will stop working. They ask questions. They confirm the case from several directions. At last they are confident that they have studied the matter as much as is necessary and confident that they have come to a correct judgement, and then they act on it.

What kills the prudent man rule today?

Here’s what guarantees that the prudent man rule today will decapitalize its victims: The monetary environment has changed. Refusing to recognize this, investment managers and investors continue to chase phantom nominal dollar gains which, adjusting for dollar loss, become real purchasing power losses. Remember this: In an inflationary or hyperinflationary environment, the prudent man rule – investing in stocks, bonds, and any other investment that pays back dollars tomorrow for dollars received today – becomes suicidal and guarantees loss.

Is it “prudent” to bet on inflation continuing? It has been since the Federal Reserve System was installed in 1913. Then a dollar equaled 0.048375 troy ounce of gold; today, 54/100,000ths of an ounce, a loss of 98.9% of its purchasing power against gold. If the dollar was mercury, it wouldn’t be strong enough to poison you in a teacup of water.

In an inflationary world, every investor must keep his eye on REAL returns, that is, inflation-adjusted returns. There’s no other kind.

Why not gold or silver?

NIH: Not Invented Here, The Conceptual Block. With all due respect, most professionals follow the crowd. They do what they see their peers do. And while now, with gold up over six times, avant-garde money managers concede it might be a good idea to put as much as 1 percent of the portfolio in gold – pitty-pat, pitty-pat — the crowd has yet to catch up.

A couple of years ago the University of Texas Endowment, pushed by a money manager named Kyle Bass, put about 3% of its $20 billion into gold. In April 2011, with the gold now worth nearly $1 billion and 5% of the portfolio, he pushed them into taking physical delivery of the gold. The reason he gave for gold in the first place was that central banks just keep on printing money. Reason for taking delivery was “If you own a paper contract where they can only deliver you 10 cents on the dollar or less, you should probably convert it to physical.” There’s a man who understands, and acts.

Is it too late? Are precious metals in a bubble?

Is It Too Late? Fear that the metals’ bull market has peaked. First, consider the primary trend. The first principle of ALL investing demands that you align your investments with the primary trend, i.e., that trend that rises or falls for 15 to 20 years. The market proverb says, “The trend is your friend.” The proverb is right.

Here are primary trend examples.

• Gold & silver rose generally from 1960 to 1980, while stocks fell from 1965 to 1982. Then gold and silver fell from 1980 to 2001 while stocks rose from 1982 to 2000.

• Silver and gold began rising again in 2001, while stocks began falling on an inflation-adjusted basis (and gold basis and silver basis) in 1999 for gold and 2001 for silver.

• The dollar began a primary downtrend in 2002 (on top of its post-1913 inevitable tendency to depreciate under the Federal Reserve’s gentle management). That promises that dollars paid back tomorrow will be worth less than dollars invested today. The institutional political, monetary, economic, and financial structure virtually guarantee dollar depreciation, and no change or reform is on the horizon. Until proven otherwise the recent debt-ceiling drama with the committee it spawned offers only more opportunity for Washington to avoid real changes. Don’t miss this: without that institutional change, the primary trend for silver & gold, the dollar & stocks, will not change.

• Under a primary downtrend for stocks and the dollar, investing in stocks and bonds aligns investors against the primary trend. “The trend is NOT your friend.” ***

Exerpted from the August 2011 Moneychanger. Used by permission. Franklin Sanders is publisher of The Moneychanger, a privately circulated monthly newsletter that focuses on gold and silver and the application of Christianity to economics, culture and family life. We have subscribed to this newsletter for more than 20 years, and consider it a must read. F$99 a year. Franklin is an active trader in gold and silver (he’ll swap your green Federal Reserve rectangles and give you real money in return). He trades with savers and investors outside Tennessee. Subscribe to his daily price report and market commentary on the website. F. Sanders, The Moneychanger, P.O. Box 178, Westpoint, Tenn. 38486 Tel. 888-218-9226

About The Author

Franklin Sanders is publisher of The Moneychanger, a privately circulated monthly newsletter that focus on gold and silver and the application of Christianity to economics, culture and family life. We have subscribed to this newsletter for more than 20 years, and consider it a must read. Franklin is an active trader in gold and silver (he’ll swap your green Federal Reserve rectangles and give you real money in return). He trades with savers and investors outside Tennessee. Subscribe to his daily price report and market commentary on the website.